Below is an extract from a commentary originally posted at www.speculative-investor.com on 24th August, 2008.

The gold market analyses put out by the likes of Gold Fields Mineral Services (GFMS), the World Gold Council (WGC) and most major banks invariably concentrate on things like jewellery demand, new mine supply, and scrap supply. This means, in effect, that they concentrate on supply/demand influences that are so small in relation to the total market for gold as to be almost irrelevant.

Consider the hypothetical example of a corporation that always increases its share count by around 1.5% per year and does so by dribbling new shares onto the market at regular intervals over the course of the year. The market knows that the total share count will be about 1.5% higher next year, and another 1.5% higher the year after next, and so on. These new shares therefore exert very little influence on the share price. Moreover, if instead of increasing its share count by 1.5% during a year the company increases it by 1.3% or 1.7%, such a change will not have a significant influence on the share price because the difference between the anticipated increase in new shares and the actual increase will be trivial compared to the total existing supply of shares.

The existing aboveground gold supply is analogous to the total supply of our hypothetical company's shares, and new mine supply is analogous to the new equity that the company dribbles onto the market every year.

In our example it will clearly be the change in demand for the overall supply of shares that will determine the company's share price, but someone who applied GFMS's standard gold-market approach when analysing supply versus demand in this hypothetical case would fixate on the few new shares that are issued each year and on changes in the demand for a tiny portion of the overall share quantity.

In the gold market the miners are almost always sellers at whatever price they are able to get at the time their gold is ready for sale, and the price they get is almost solely determined by the investment/speculative demand for the total aboveground gold supply. It is also worth mentioning that the investment/speculative demand for gold trends inversely to the investment demand for financial assets such as stocks and bonds, which is why the current major upward trend in gold commenced during 1999-2001 -- at around the same time as the major upward trend in financial assets ended. The gold miners have exerted very little influence on this trend, as have changes in jewellery demand and scrap supply. If the amount of annual gold production or the level of jewellery demand were to vary by 10 or 20 percent there would, of course, be some effect on price, but the effect would be negligible compared to the effect of changes in investment demand.

Now, investment demand is a factor in all commodity markets, not just the gold market. Commodities are, after all, considered to be an asset class. Gold is very different from all the other commodities, though, because a large chunk of gold's aboveground supply is held for store-of-value purposes. There is, for instance, a large aboveground supply of copper, but as far as the market price of copper is concerned this aboveground supply may as well not exist because even if the copper price went to $50/pound it probably wouldn't make economic sense to tear down large buildings or rip the plumbing out of your house in order to access the copper. The difference between the supply situations of gold and the base metals is that the amount of base metal in ready-for-sale form is dominated by mine supply, whereas the amount of gold in ready-for-sale form is dominated by the existing aboveground supply. This is why changes in the demand for the existing aboveground gold inventory are orders of magnitude more important, as far as the market price is concerned, than equivalent percentage changes in mine supply or jewellery demand.

An additional, and related, point is that the investment demand for a commodity can often be satisfied without taking physical possession of the commodity. As a consequence, a sizeable portion of the overall demand for gold is satisfied by claims to gold as opposed to the actual gold. Many investors, for example, are quite content knowing that their gold is securely stored in a vault in a distant country. They don't need to lay their hands on physical metal; what they want are the benefits conferred by the ownership of gold, regardless of where the gold happens to be located.

Lastly, gold's large aboveground supply could cause it to fare poorly relative to other commodities during the early stages of a 'great inflation cycle' and relatively well during the latter stages. The reason is that during the early stages of the cycle the effects of inflation will often be confused with real economic growth, but as the inflation (currency debasement via increasing currency supply) continues it will gradually become clear to the masses that their money is being systematically destroyed. Store-of-value considerations will then begin to dominate the financial world, and the commodities generally considered to be the most useful stores of value are those that: a) are readily available in a tradable form, b) are fungible (meaning that one unit of the commodity is substantially the same as any other unit of the commodity), c) have high values relative to their physical sizes, d) have large total supplies in relation to the amounts consumed in industrial processes, and e) have long track records as good stores of value. Gold and silver are the ONLY commodities that fit all these criteria, with gold offering the best fit.

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